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Real estate grounds the dollar

We are all aware of the sub prime lending led real estate crisis that the US is currently going through. But what has this got to do with the value of the dollar, which seems to have displayed persisting weakness for sometime now?

Let’s try and understand what currency values indicate. In general, like common stocks reflect the health of a corporation, the value of a nation’s currency is indicative of the economic health of the nation.

The value of a nation’s currency is measured relative to that of other select nations. Thus, the value of the US dollar is usually measured against the Euro, Yen and the Pound amongst other currencies.

Having understood that there is a general relationship between the economic health of a nation and the value of its currency, let’s analyze how the current real estate bust is affecting the value of the dollar.

The value of a currency is primarily affected by the level of inflation in the economy and the prevailing interest rates. Inflation and interest rates are themselves closely interlinked, with interest rate being a key tool that central banks use to manage the former, as well as the health of the economy.

The past few years of low interest rates and easy loans for home buyers fuelled property prices. A large part of these loans were sub-prime loans, given to buyers with poor credit history. Some of these loans were flexible loans and carried low mortgage payments for the first few years after which they were to reset in line with market interest rates. From the time these loans were given out until the time they were ready to reset, market interest rates moved up considerably due to Fed having raised its benchmark rate. This implied that the borrowers were to suddenly face huge monthly mortgage payment liabilities, which they could possibly not manage to pay. Defaults started and a large number of properties came up for sale. This led to prices stagnating or moving downwards as new buyers were far from few, with interest rates having shot up. Due to rising interest rates, these flexible loans led to a situation where the fixed payments made did not even cover the interest liability and the outstanding interest for the period got added up to total outstanding liability. In several cases the total outstanding after the reset period added up to greater than the purchase/present value of the property leading to the situation called ‘upside down’ in the loan. Imagine the plight of the buyer who had thought that he could always sell the property and make some money. He now faced a situation, where the outstanding loan was higher than what he could sell the property for.                                                          

Fed’s dilemma
           
If the Fed were to significantly lower interest rates, it might become possible to shore up the sagging real estate market. However, policy does not permit such knee jerk reactions and moreover, interest rate change also have to take into account inflation levels and projected inflation. The news on the inflation front is not very heartening. U.S. consumer prices rose the most in more than two years in November on record energy costs, reinforcing the Fed’s concern that inflation will erode confidence in the economy. The consumer price index rose 0.8 percent in November, up from 0.3 percent the previous month, according to the U.S. Labor Department statement on December 14, 2007. With, crude prices showing no signs of relenting, inflation will continue to pose a threat to the US economy. This implies that the Fed’s hands are tied. If it lowers interest rates, it may push liquidity into the system leading to a higher inflationary pressure, a condition the Fed is completely averse to. Thus, the Fed needs to be very careful in crafting its interest rate movements.

Early last month, the Federal Reserve cut interest rates for the third successive time in order to prevent the rapidly deteriorating US housing market from dragging the world’s biggest economy into recession. The cut was a marginal 25 basis points. However, these successive cuts have led to a depreciating dollar and thus our corollary, ‘Real estate grounds the dollar’.